Risking Less and Prospering using Real Return Bonds? [RRBs]

Asset allocation, risk, diversification and rebalancing. Pros/cons of hiring a financial advisor. Seeking advice on your portfolio?
longinvest
Veteran Contributor
Veteran Contributor
Posts: 3956
Joined: 10 Sep 2012 17:26
Location: QC

Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

I'm starting this thread on Zvi Bodie's book Risk Less and Prosper.

Zvi Bodie thinks that many investors are not aware of how much risk they are bearing. As a proponent of safety-first investing, he emphasizes the need for a minimum basic income that is safe, whether for retirement, for higher education, or for other long-term goals.

He is a huge fan of government-backed inflation-indexed securities. As his book is written for U.S. investors, he discusses the use of U.S. Treasury Inflation Protected Securities (TIPS) and inflation-protected U.S. government savings bonds (I Bonds).

The Canadian equivalent of TIPS are Real Return Bonds (RRBs). But, unlike TIPS which are frequently issued with various maturities (5, 10, and 30 years) resulting in a 8-year total-market duration, RRBs are only issued with long maturities (30 years and higher) and mature at intervals 5 years apart*, resulting in a 16-year total-market duration. As for I Bonds, which could be considered as inflation-indexed cash (they have no volatility), there is no Canadian equivalent.

* The most recent issues mature 3 years apart in 2041, 2044, and 2047.

This will be an ongoing thread to discuss the principles presented in the book, to debate the use of RRBs, and to investigate how a Canadian investor could put in practice the ideas of safety-first investing.
Last edited by longinvest on 07 Nov 2016 20:52, edited 1 time in total.
Variable Percentage Withdrawal (finiki.org/wiki/VPW) | One-Fund Portfolio (VBAL in all accounts)
longinvest
Veteran Contributor
Veteran Contributor
Posts: 3956
Joined: 10 Sep 2012 17:26
Location: QC

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

Let me start the discussion.

Risking less and prospering using RRBs. Isn't that an oxymoron?

Risking less? It's a joke, right? In 1994, RRBs had a loss of -13.7%. Again in 2013, they had loss of -13.1%. Compare that to the worst loss of the nominal bond market of -4.3 in 1994 and the tiny loss of -1.2% in 2013.

Considering their longer duration, aren't RRBs effectively riskier than nominal bonds?

Prospering? Another joke, maybe? The average yield to maturity (YTM) of the market is currently 0% (real). Even on the long end of the market, things are not much better. The 1.50% RRB maturing in 2044 is selling at a premium reducing its yield to 0.23%, less than the MER on the cheapest RRB ETF (ZRR).

With their low and often negative real yields, aren't RRBs a perfect investment vehicle to end up in poverty by trailing inflation after fees?

What do you think? :mrgreen:
Variable Percentage Withdrawal (finiki.org/wiki/VPW) | One-Fund Portfolio (VBAL in all accounts)
User avatar
ghariton
Veteran Contributor
Veteran Contributor
Posts: 15954
Joined: 18 Feb 2005 18:59
Location: Ottawa

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by ghariton »

longinvest wrote:Considering their longer duration, aren't RRBs effectively riskier than nominal bonds?
Yes, RRBs are subject to (real) interest risk, sometimes known as market risk. But nominal bonds are subject to the risk of unanticipated inflation, as well as some market risk. It's a balance.

In my case, I hold individual RRBs, and intend to hold them to maturity. That effectively reduces market risk to almost zero -- if I'm reinvesting coupons, there is the problem of the conditions under which I can reinvest. But if I'm spending the coupons, or using them to increase some other holding (U.S. equity, say), then even that minimal market risk goes away.

So individual RRBs give me a certain amount of money -- certain in real terms -- available to me at maturity, whether to spend, or reinvest, or give away. Nominal bonds can't do that.

As you point out, individual RRBs are available in five-year maturity increments. That is a problem, but in my view a minor one. First, the outstanding bonds are premium bonds, so you are effectively getting a return of capital (cashing in some of the bond) every six months, with no transaction costs. If that's not adequate to provide money within each five year period between maturities, there are strips. Admittedly that market is highly illiquid, and I avoid it, but some use it. Third, as you also point out, inflation is unlikely to do that much damage over a period as short as five years. Make sure that enough RRBs mature every five years to cover your needs until the next maturity, and invest in a GIC ladder or whatever.
Prospering? Another joke, maybe? ... With their low and often negative real yields, aren't RRBs a perfect investment vehicle to end up in poverty by trailing inflation after fees?
Yes. But nominal bonds are also yielding a negative real return. So it's a question of choosing between (1) a nominal bond with a negative real return, (2) a RRB with insurance against unanticipated inflation at the cost of a slightly more negative real return (although sometimes the return on a RRB is higher than on the corresponding nominal -- go figure), and (3) cash, with the most negative return of the three and no protection whatsoever against inflation, anticipated or unanticipated. Interestingly, many choose the third for their fixed income component (I include HISAs, etc., as cash).

The other consideration is that my primary reason for holding fixed income is not to "prosper" in terms of making high returns or indeed any returns at all, but rather to reduce risk to a degree that I can live with, psychologically. So to the degree that RRBs allow me to hold (and hold, and hold) my equities without panicking, yes, they contribute to my prosperity.

George
The juice is worth the squeeze
8Toretirement
Contributor
Contributor
Posts: 225
Joined: 26 Nov 2014 14:55

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by 8Toretirement »

I am 53, RRB's don't factor into my equation for the following reasons:

1. RRB's increase the volatility of a portfolio, compared to a shorter term bond mix as mentioned above. My strategy is safety, with moderate growth, so I have focused on maximizing our savings to be placed in investments over return, thus lowering the volatility of my portfolio since the increased savings lowers the return required to achieve my goal.
2. I have a pension from military service, although it lowers my CPP funds at 65 which I view as a hedge for inflation. OAS same hedge through cost of living adjustments.
3. I have a mix of very short term bonds, and a 1-5 yr laddered IShares Government Bond ETF, and laddered 2-5 yr GIC's.
4. We are debt free, which minimizes my exposure to interest rate spikes.
5. I believe in a personal rate of inflation, which means I can choose my price points. If new cars get too expensive then I would substitute for used, or delay purchasing, lowering my exposure to inflation if desired. Ack there are some goods such as groceries I cannot fully mitigate.
6. My 40% conservative broad based market ETF's and select stocks mostly in real estate should capture a percentage of inflation through pricing power of goods.
7. RRB's are really a hedge for hyper-inflation but RRB's perform poorly in a deflationary environment, what you get is a hedge to one side of a possible outcome with no downside protection.

Lastly, current BoC policy is set to control inflation, my exposure to short term bonds and a GIC ladder will allow me to capture most of any inflation spikes through interest spreads on the front end of a laddered bond and GIC component but at a lag. However, while RRB's will taper off when spikes are controlled I can reset and capture a longer term spreads by adjusting my term towards the five year rate.
User avatar
big easy
Veteran Contributor
Veteran Contributor
Posts: 1737
Joined: 27 Jul 2006 11:57
Location: Vancouver BC

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by big easy »

8Toretirement wrote:7. RRB's are really a hedge for hyper-inflation but RRB's perform poorly in a deflationary environment, what you get is a hedge to one side of a possible outcome with no downside protection.
I'm not sure what you mean by "no downside protection". If I've got it right, they won't soar like nominal bonds during deflationary periods, but they should maintain their purchasing power in real deflated dollars. Of course in this scenario, even cash would be better than a RRB with coupons and maturity value decreasing at the rate of deflation.
"Everybody has a plan until they get punched in the face." Mike Tyson
User avatar
ghariton
Veteran Contributor
Veteran Contributor
Posts: 15954
Joined: 18 Feb 2005 18:59
Location: Ottawa

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by ghariton »

8Toretirement wrote:I1. RRB's increase the volatility of a portfolio, compared to a shorter term bond mix
That's only relevant if you sell before maturity.

I would agree that one shouldn't park one's emergency reserve in RRBs. For longer-term investments, however, e.g. accumulating a retirement nest egg at 65, the problem doesn't arise.
2. I have a pension from military service, although it lowers my CPP funds at 65 which I view as a hedge for inflation. OAS same hedge through cost of living adjustments.
Yes, RRBs are primarily who don't have a fully indexed DB pension, or whose pension is inadequate. Of course, if you have an adequate indexed DB pension, you should be 100% in equities, not playing around with short nominal bonds.
3. I have a mix of very short term bonds, and a 1-5 yr laddered IShares Government Bond ETF, and laddered 2-5 yr GIC's.
Provides good liquidity, and is useful in emergency reserves, saving up for short term goals, etc. But the inflation protection of such investments is open to doubt. For example, during much of the three decades following World War II, the real return on such instruments was negative.
4. We are debt free, which minimizes my exposure to interest rate spikes.
Yes. Of course, interest rate spikes still affect you, by causing drops in both bonds and equities. Not clear what this has to do with the merits of RRBs versus other instruments.
5. I believe in a personal rate of inflation, which means I can choose my price points. If new cars get too expensive then I would substitute for used, or delay purchasing, lowering my exposure to inflation if desired. Ack there are some goods such as groceries I cannot fully mitigate.
Congratulations on being so flexible in your life style. But by the same token, such flexibility suggests to me that your ability to absorb losses from equities is greater than average. Again, a 100% equity portfolio would seem indicated.
6. My 40% conservative broad based market ETF's and select stocks mostly in real estate should capture a percentage of inflation through pricing power of goods.
Providing that you are diversified widely, and certainly beyond Canada. Remember, our economy is concentrated on natural resources and financial services (and real estate). A large part of what we spend our money on, is imported.
7. RRB's are really a hedge for hyper-inflation but RRB's perform poorly in a deflationary environment, what you get is a hedge to one side of a possible outcome with no downside protection.
Depending on your definition of hyperinflation, but I would probably disagree. For example, 5% to 10% inflation is not hyperinflation, but certainly would play havoc with nominal fixed income instruments. As for deflation, my first posts fifteen years ago on a predecessor forum was to disagree with those who saw deflation just around the corner.

Anyway, I don't see RRBs as protection against expected inflation, no matter what the level. Rather, I see them as protection against unanticipated inflation -- and who knows at what level unanticipated inflation will come in.
Lastly, current BoC policy is set to control inflation, my exposure to short term bonds and a GIC ladder will allow me to capture most of any inflation spikes through interest spreads on the front end of a laddered bond and GIC component but at a lag. However, while RRB's will taper off when spikes are controlled I can reset and capture a longer term spreads by adjusting my term towards the five year rate.
While there is a relationship between expected inflation and nominal interest rates, empirically the relationship is weak, and can take a decade or two to assert itself.

George
The juice is worth the squeeze
longinvest
Veteran Contributor
Veteran Contributor
Posts: 3956
Joined: 10 Sep 2012 17:26
Location: QC

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

ghariton wrote:
longinvest wrote:Considering their longer duration, aren't RRBs effectively riskier than nominal bonds?
Yes, RRBs are subject to (real) interest risk, sometimes known as market risk. But nominal bonds are subject to the risk of unanticipated inflation, as well as some market risk. It's a balance.

In my case, I hold individual RRBs, and intend to hold them to maturity. That effectively reduces market risk to almost zero -- if I'm reinvesting coupons, there is the problem of the conditions under which I can reinvest. But if I'm spending the coupons, or using them to increase some other holding (U.S. equity, say), then even that minimal market risk goes away.

So individual RRBs give me a certain amount of money -- certain in real terms -- available to me at maturity, whether to spend, or reinvest, or give away. Nominal bonds can't do that.
I was asking a trick question. It all goes back to how one defines risk. If one defines risk as volatility, then an RRB with its longer duration than a nominal federal bond of similar maturity is riskier. But if, instead, risk is defined as the odds of not having preserved a specific purchase power on a specific date far away in the future (near the RRB's maturity), then the RRB is safer.
ghariton wrote:
Prospering? Another joke, maybe? ... With their low and often negative real yields, aren't RRBs a perfect investment vehicle to end up in poverty by trailing inflation after fees?
Yes. But nominal bonds are also yielding a negative real return. So it's a question of choosing between (1) a nominal bond with a negative real return, (2) a RRB with insurance against unanticipated inflation at the cost of a slightly more negative real return (although sometimes the return on a RRB is higher than on the corresponding nominal -- go figure), and (3) cash, with the most negative return of the three and no protection whatsoever against inflation, anticipated or unanticipated. Interestingly, many choose the third for their fixed income component (I include HISAs, etc., as cash).

The other consideration is that my primary reason for holding fixed income is not to "prosper" in terms of making high returns or indeed any returns at all, but rather to reduce risk to a degree that I can live with, psychologically. So to the degree that RRBs allow me to hold (and hold, and hold) my equities without panicking, yes, they contribute to my prosperity.
You seem to share some Bodie's safety-first investing principles. He wants us to reach prosperity and he does not claim that it should be built solely using inflation-indexed bonds. But, he thinks that it would be a mistake not to cover one's bases first, before shooting for the heights of high profits with risky assets. Mainly, he wants us to make sure our plan will still work if risk shows up.
Variable Percentage Withdrawal (finiki.org/wiki/VPW) | One-Fund Portfolio (VBAL in all accounts)
longinvest
Veteran Contributor
Veteran Contributor
Posts: 3956
Joined: 10 Sep 2012 17:26
Location: QC

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

8Toretirement wrote:Lastly, current BoC policy is set to control inflation, my exposure to short term bonds and a GIC ladder will allow me to capture most of any inflation spikes through interest spreads on the front end of a laddered bond and GIC component but at a lag. However, while RRB's will taper off when spikes are controlled I can reset and capture a longer term spreads by adjusting my term towards the five year rate.
8Toretirement,

You prefer to invest into a riskier asset (GICs) because you expect it to deliver higher returns than a safer asset (RRBs)*.

Did I get that right? :twisted:

* Of course, I'm talking about inflation risk, here; not about volatility risk.
Variable Percentage Withdrawal (finiki.org/wiki/VPW) | One-Fund Portfolio (VBAL in all accounts)
User avatar
adrian2
Veteran Contributor
Veteran Contributor
Posts: 13333
Joined: 19 Feb 2005 08:42
Location: Greater Toronto Area

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by adrian2 »

8Toretirement wrote:2. I have a pension from military service, although it lowers my CPP funds at 65 which I view as a hedge for inflation.
You have the above the other way around.

CPP is not affected by any other pension / income you may have. Your military pension calculation may (or may not) be affected at the "standard" retirement age by the presumption that you'll start getting CPP.
Imagefiniki, the Canadian financial wiki
“It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong.” [Richard P. Feynman, Nobel prize winner]
8Toretirement
Contributor
Contributor
Posts: 225
Joined: 26 Nov 2014 14:55

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by 8Toretirement »

adrian2 wrote:
8Toretirement wrote:2. I have a pension from military service, although it lowers my CPP funds at 65 which I view as a hedge for inflation.
You have the above the other way around.

CPP is not affected by any other pension / income you may have. Your military pension calculation may (or may not) be affected at the "standard" retirement age by the presumption that you'll start getting CPP.
Government pensions are integrated with CPP, there is a reduction in the pension to offset the integration at 65.
8Toretirement
Contributor
Contributor
Posts: 225
Joined: 26 Nov 2014 14:55

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by 8Toretirement »

longinvest wrote:
8Toretirement wrote:Lastly, current BoC policy is set to control inflation, my exposure to short term bonds and a GIC ladder will allow me to capture most of any inflation spikes through interest spreads on the front end of a laddered bond and GIC component but at a lag. However, while RRB's will taper off when spikes are controlled I can reset and capture a longer term spreads by adjusting my term towards the five year rate.
8Toretirement,

You prefer to invest into a riskier asset (GICs) because you expect it to deliver higher returns than a safer asset (RRBs)*.

Did I get that right? :twisted:

* Of course, I'm talking about inflation risk, here; not about volatility risk.
I hold bonds and GIC's for one reason. Reduction of risk. Risk is nominally perceived through volatility in a portfolio. Short durations FI is the best way to minimize volatility. RRB's are long duration assets, higher volatility. So from my point of view they are riskier than short duration FI assets.
8Toretirement
Contributor
Contributor
Posts: 225
Joined: 26 Nov 2014 14:55

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by 8Toretirement »

Lastly, current BoC policy is set to control inflation, my exposure to short term bonds and a GIC ladder will allow me to capture most of any inflation spikes through interest spreads on the front end of a laddered bond and GIC component but at a lag. However, while RRB's will taper off when spikes are controlled I can reset and capture a longer term spreads by adjusting my term towards the five year rate.
While there is a relationship between expected inflation and nominal interest rates, empirically the relationship is weak, and can take a decade or two to assert itself.

George[/quote]

George, In 1991 the Bank of Canada and the Minister of Finance agreed on an inflation-control target framework to guide Canadian monetary policy. The target agreement has been renewed to the end of 2021.

From Sep 1991-Sep 2016 the Consumer Price Index has risen 1.77%. I believe the BoC has the best means to control inflation and investors can hedge by holding short duration FI instruments. 25 years of data.

RRB's with 30 year durations are best held by pension funds with long term payment risk. The majority of Canadians have moderate protection from inflation without doing anything through CPP and OAS.
User avatar
adrian2
Veteran Contributor
Veteran Contributor
Posts: 13333
Joined: 19 Feb 2005 08:42
Location: Greater Toronto Area

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by adrian2 »

8Toretirement wrote:
adrian2 wrote:
8Toretirement wrote:2. I have a pension from military service, although it lowers my CPP funds at 65 which I view as a hedge for inflation.
You have the above the other way around.

CPP is not affected by any other pension / income you may have. Your military pension calculation may (or may not) be affected at the "standard" retirement age by the presumption that you'll start getting CPP.
Government pensions are integrated with CPP, there is a reduction in the pension to offset the integration at 65.
Which is exactly my point: CPP is not affected by your pension, but OTOH your pension is affected by the CPP. Your initial quote had it the other way around.
Imagefiniki, the Canadian financial wiki
“It doesn't matter how beautiful your theory is, it doesn't matter how smart you are. If it doesn't agree with experiment, it's wrong.” [Richard P. Feynman, Nobel prize winner]
8Toretirement
Contributor
Contributor
Posts: 225
Joined: 26 Nov 2014 14:55

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by 8Toretirement »

ghariton wrote:
8Toretirement wrote:I1. RRB's increase the volatility of a portfolio, compared to a shorter term bond mix
That's only relevant if you sell before maturity.

I would agree that one shouldn't park one's emergency reserve in RRBs. For longer-term investments, however, e.g. accumulating a retirement nest egg at 65, the problem doesn't arise.


Respectfully, the older the individual the shorter the time horizon. RRB's are nominally 30 year durations. If you purchase mid duration products you have the potential for capital loss due to price premiums and ask/purchase spreads. If the investor is retired then longer duration products that are more volatile produce increased risk, especially when the retiree may need withdrawals. Decreasing volatility during the withdrawal phase would be more consistent with minimizing risk.

Add to this the potential for an older investor to lose the ability to manage their own portfolios and the risk could be compounded as the portfolio mix could be adjusted by a new manager at the wrong time.

I am talking generalities here, not specific to any specific investor.
8Toretirement
Contributor
Contributor
Posts: 225
Joined: 26 Nov 2014 14:55

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by 8Toretirement »

7. RRB's are really a hedge for hyper-inflation but RRB's perform poorly in a deflationary environment, what you get is a hedge to one side of a possible outcome with no downside protection.
Depending on your definition of hyperinflation, but I would probably disagree. For example, 5% to 10% inflation is not hyperinflation, but certainly would play havoc with nominal fixed income instruments. As for deflation, my first posts fifteen years ago on a predecessor forum was to disagree with those who saw deflation just around the corner.

Anyway, I don't see RRBs as protection against expected inflation, no matter what the level. Rather, I see them as protection against unanticipated inflation -- and who knows at what level unanticipated inflation will come in.


I don't see deflation anywhere in the future, however, it has occurred before, and most people don't know one feature of RRB's that is relevant compared to normal bonds.

There is no guarantee of principal on RRB's.

This interpretation can be found in a prospectus on RRBs at the Bank of Canada Web site. It says:

Conventional Bonds versus Real Return Bonds
While the nominal yield to maturity and nominal cash flows are known in advance with conventional
bonds (for example an 8% per annum Government of Canada bond purchased at par has a nominal yield of 8%
per annum), the real yield (i.e. the yield after considering the effect of inflation on the purchasing power of
money) depends on inflation throughout the term of the bonds. Even though the nominal amount due on maturity
is known in advance, the purchasing power of that amount at such time is uncertain and may be more or
less than the purchasing power of the original principal.
In the case of the Bonds, the real yield to maturity and real cash flows are known in advance; however, the
nominal yield depends on inflation throughout the term of the Bonds. In addition, while the purchasing power
of the amount due on maturity is known in advance, the actual nominal amount due on maturity is uncertain
and may be more or less than the nominal amount of the original principal.

loss of principle would be due to extended deflation, in this scenario the principal amount, especially on secondary purchase RRB's could be less than the nominal amount of the original purchase price.
longinvest
Veteran Contributor
Veteran Contributor
Posts: 3956
Joined: 10 Sep 2012 17:26
Location: QC

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

8Toretirement wrote:I hold bonds and GIC's for one reason. Reduction of risk. Risk is nominally perceived through volatility in a portfolio. Short durations FI is the best way to minimize volatility. RRB's are long duration assets, higher volatility. So from my point of view they are riskier than short duration FI assets.
8Toretirement,

Why do you define risk as volatility?
Variable Percentage Withdrawal (finiki.org/wiki/VPW) | One-Fund Portfolio (VBAL in all accounts)
User avatar
ghariton
Veteran Contributor
Veteran Contributor
Posts: 15954
Joined: 18 Feb 2005 18:59
Location: Ottawa

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by ghariton »

8Toretirement wrote:RRB's are nominally 30 year durations. If you purchase mid duration products you have the potential for capital loss due to price premiums and ask/purchase spreads.
I disagree. What you have purchased is a premium bond (with yields being what they are these days). The premium is paid out to you gradually over the remaining life of the bond, as part of the coupon.

The one thing that is certain is the amount you will receive upon maturity, i.e. the face value adjusted for inflation from time of issue to time of maturity. (Also the coupon payments, based on face value adjusted for inflation.) That means that, if I believe that I will need $1 million at age 65 to fund my retirement, I can buy a residual which will pay exactly that, in inflation-adjusted terms. Or I can buy a regular RRB, which will also give me coupons along the way, adjusted for inflation, that are also certain. (I set aside the possibility that the Government of Canada will become insolvent.) I have effectively insured against capital erosion, the price being a slightly lower yield than I would get on a nominal bond of the same maturity.
... longer duration products that are more volatile produce increased risk...
I'm with longinvest on this one. Yes, volatility is A measure of risk, but far from the only one. Maximum drawdown is another. Not being able to match future liabilities with current assets is yet another. Different measures of risk are appropriate in different circumstances, and the choice will depend on the question one is trying to answer.

In particular, if one is looking at a long term horizon (buy and hold), short term volatility is just noise. Even sequence-of-returns risk goes away.
Add to this the potential for an older investor to lose the ability to manage their own portfolios and the risk could be compounded as the portfolio mix could be adjusted by a new manager at the wrong time.
That risk exists regardless of the composition of the initial portfolio. You have to trust your advisor or trustee or PoA, and also his or her succession plan. Not easy to find one, I know.

George
The juice is worth the squeeze
User avatar
ghariton
Veteran Contributor
Veteran Contributor
Posts: 15954
Joined: 18 Feb 2005 18:59
Location: Ottawa

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by ghariton »

8Toretirement wrote:There is no guarantee of principal on RRB's.
The context is given in the passage from the Bank of Canada that you subsequently quote. RRBs guarantee principal in real terms, but not in nominal terms. Nominal bonds guarantee principal in nominal terms, but not in real terms. For most people and most applications, the former is a far more important guarantee than the latter. (ISTM that the latter is useful only if you have a long term debt which is fixed in nominal dollars, such as a mortgage. I can't think of any other significant examples.)

George
The juice is worth the squeeze
longinvest
Veteran Contributor
Veteran Contributor
Posts: 3956
Joined: 10 Sep 2012 17:26
Location: QC

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

8Toretirement wrote:loss of principle would be due to extended deflation, in this scenario the principal amount, especially on secondary purchase RRB's could be less than the nominal amount of the original purchase price.
8Toretirement,

I agree with George. What many investors worry about is purchase power. An RRB preserves the purchase power of its principal and of its coupons as measured by the CPI. Once purchase power is preserved, the nominal amount has no impact other than for taxes (a credit for capital loss, in this case, in a non-registered account).
Variable Percentage Withdrawal (finiki.org/wiki/VPW) | One-Fund Portfolio (VBAL in all accounts)
longinvest
Veteran Contributor
Veteran Contributor
Posts: 3956
Joined: 10 Sep 2012 17:26
Location: QC

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by longinvest »

Let's get back to the principles of Bodie's Risk Less and Prosper book.

Bodie is a proponent of using an insurance perspective when planning investments. As I wrote earlier, Bodie emphasizes the need for a minimum basic income that is safe. His approach is based on setting goals and building a robust plan to reach them.

He first starts by asking us to determine our financial goals and to quantify them. Then, as a second step, he asks us to reduce our goals to their bare essentials; to imagine the minimum we will absolutely need. This serves to draw the line on risk. He writes:
In Risk Less and Prosper, Zvi Bodie wrote:By establishing the minimal needs that you can't do without, you're also specifying what you cannot afford to lose to risk. This perspective breaks with convention because it measures risk in terms of possible shortfall amounts, and not the odds of falling short.
This is the cornerstone of his approach. He considers that risk is not about volatility; it is about meeting our minimum financial goals or not, and the size of the shortfall when we fail to meet our objectives.

He writes:
In Risk Less and Prosper, Zvi Bodie wrote:If you hear the catchphrase that an investment portfolio has a 90 percent chance of getting you to your goals, remember to flip the statement on its head. Ask how much you stand to lose. Then weigh the consequences.
We've been taught by the financial industry to build portfolios that increase the odds of success. Bodie's approach is drastically different; it puts the emphasis on the shortfall amount and consequences of failure.

Let's be clear, here. He is talking about safely meeting our minimal needs which are the bare essentials: shelter, clothing, food, and what it takes to maintain good health. The distinction between needs and wants determine the rock-bottom baseline--the level of future income our investments must absolutely yield.

This changes the measure of success. Success won't be about beating the S&P 500 or some other index, or even matching it. Success will be about meeting our minimum goals or not.

What do you think? Does this make sense to you, so far?
Variable Percentage Withdrawal (finiki.org/wiki/VPW) | One-Fund Portfolio (VBAL in all accounts)
User avatar
ghariton
Veteran Contributor
Veteran Contributor
Posts: 15954
Joined: 18 Feb 2005 18:59
Location: Ottawa

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by ghariton »

longinvest wrote:What do you think? Does this make sense to you, so far?
I haven't read the book, but I did go through the 2000-2001 unpleasantness and, newly retired, lost two thirds of our money. I went back to work full time for some five years before easing back to part time work.

The lesson I learned is that I didn t want to go through that again. To sleep at night in retirement, I need a safe portion of my portfolio that I can fall back on with absolute confidence that it will be there. As I ve said before, that safe position allows me to invest the rest of my money in equities, and ride out turbulence with equanimity. For example, I wouldn t be unduly disturbed by a 50% fall in the value of my equity holdings, and wouldn t be panicked into selling anything.

Having lived through the 1970s and 1980s, I rank unanticipated inflation as the biggest risk to my portfolio. I also come from a region of the world where hyperinflation happens from time to time. Accordingly, I am eager to buy insurance against inflation.

From your posts, it seems to me that this is roughly consistent with Bodie s approach. I should note that it is wholly consistent with Shakespeare s Iron Rule (though details may differ), which he enunciated soon after I had come to my approach. His posting his Iron Rule, and the reasons for it, gave me reassurance that I was on the right track.

Not that it is relevant, but I don t fear deflation. If we didn t get sustained deflation in 2008-2009, it is unlikely we will get it in the next decade. Even if deflation does happen, it will be mild, given central banks toolkits.

Obviously YMMV. For example, I find that younger people, who never lived through high inflation, tend to minimize its risk. They may be right, and 1975-1985 may have been a black swan. But I don t think it is prudent to cast history completely aside.

George
The juice is worth the squeeze
gobsmack
Contributor
Contributor
Posts: 447
Joined: 04 Sep 2015 13:16

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by gobsmack »

I don't know much about this topic and I am learning from the discussion in this thread.

I think it is difficult to talk about inflation without considering what may be happening around the world. If inflation is only impacting Canada, an income stream from abroad (e.g., XAW) should offer a decent degree of protection (one more reason to try and diversify). I think inflation in the US is a scarier scenario, no? The Fed would start to raise rates in order to fight it and other central banks would be forced to follow along even when not appropriate. They would be forced to do so in order to avoid the devaluation of their currencies and inflation on imports as a result. Perhaps what we should really be concerned about is protection against inflation in the US? I single out the US because of the size of their economy and the amount we trade with them.
User avatar
cannew
Contributor
Contributor
Posts: 348
Joined: 17 Mar 2010 10:59

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by cannew »

Don't own any bonds and never have. 100% Cdn equities and extremely happy with the income from our stocks. Not worried about inflation, drop in markets, or lack of diversification. As long as the companies continue to pay and increase their dividends I'm happy. Retired 12 years and our income received has increased each year. As we don't need all of it, we reinvest most of the dividends. What more does one need?
User avatar
Quebec
Veteran Contributor
Veteran Contributor
Posts: 1645
Joined: 24 Oct 2009 16:49
Location: Quebec City

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by Quebec »

Ok, I've read the book.

Thanks Longinvest for suggesting this book, which is very different from those I’ve usually been reading (including ‘Stocks for the long run’ by Siegel!, which is criticized intensely) and brings a fresh perspective.

Here is my summary. Note that the book is aimed at US investors, but the basic principles apply anywhere.

RISK LESS AND PROSPER, your guide to safer investing
By Zvi Bodie & Rachelle Taqqu

Chapter 1 "Changing the game"
In retirement planning or when investing for tertiary education, the real risk is losing more money than you can afford. Retirement cannot be postponed indefinitely, and "your child needs to attend college within a narrow window of time". Safe investments must cover the bare essentials, the portion of the planning that is a ‘need’ as opposed to a ‘want’.

Chapter 2 "Picturing your destination"

List down your goals and prioritize them. Separate essential ‘needs’ from ‘wants’ for each goal. For example, a place to live is a need, but lots of space and a cleaning service is a want. Assign a time deadline to each goal and assign a price, in today’s dollars, again using the distinction between needs and wants.

Chapter 3 "Paying up"

Introduction to human capital, creating a lifetime budget, a bit of behavioural finance. Human capital and its uncertainty (depending on job type, etc.) must be taken into account in financial planning, for example when assessing a person’s ability to take (investment) risk. The goal based approach "views the future in terms of spending and not in terms of a mechanical rate of return or a magic number. It’s geared instead to safeguard your basic needs." If these basic goals can’t be attained through safe investments, then the solution is not to increase risk by adding stocks. Rather, change your goals, save more, or work longer.

Chapter 4 "The mismeasure of risk" and Chapter 5 "The allure of hope"
People have too much faith in stocks and believe that time will fix any downturns. In the long run we are dead. Japan 1989, USA 1929.

Chapter 6 "Your personal risk profile"

Investment risk is "the chance of falling short of your goals, not the volatility of what you own". Risk capacity, your ability to take risk, is "an objective measure that reflects how much money you can afford to lose, even on a worse case, without impairing your minimal goals". Whereas risk tolerance is more subjective, a question of preference, a sleep factor. This can be assessed using tests.

Chapter 7 "Finding the safe investment zone"
Between 1973 and 1982, the cost of living went up 2.6 times; no one can predict future inflation. The solution is TIPS, which guarantee a real rate of return (even though this rate might be slightly negative). Details of TIPS and I Bonds are presented. Best way to buy TIPS in registered accounts is at auction with a broker (4 times a year only). Build a TIPS ladder to "match your upcoming needs once you stop working". An alternative is a TIPS mutual fund or ETF, but these funds are imperfect hedges against inflation, since real interest rates could rise. If buying a fund, "try to match duration to your own personal investing horizon to the extent possible" to provide the best protection against inflation, although shorter durations have less exposure to real interest rate risk.
---- Comment: these last notions could be much better explained and discussed.

Chapter 8 "The art of matchmaking"
Match your investments with your planned spending. Buy individual TIPS using a ladder and hold to maturity to provide funds when needed. Market price fluctuations can then be ignored.
---- Comment: in theory this seems like a very good idea, but it does not seem straightforward to actually put into practice, since TIPS maturities are limited to 5, 10 and 30 years, and the authors recommend avoiding the secondary market. The year-by-year TIPS ladder is not something that can be implemented instantly.

Chapter 9 "Investing safely for education"
Mostly US-specific stuff: 529 plans, etc.

Chapter 10 "Choosing risky investments"
Risky investments will fund the goals beyond the basic necessities. Buy index funds to cover US stocks and international stocks. Costs matter.

Chapter 11 "How to choose an advisor"
Fiduciary duty, etc.
Imagefiniki, the Canadian financial wiki: a knowledge base of financial subjects written from a Canadian perspective
User avatar
Quebec
Veteran Contributor
Veteran Contributor
Posts: 1645
Joined: 24 Oct 2009 16:49
Location: Quebec City

Re: Risking Less and Prospering using Real Return Bonds? [RRBs]

Post by Quebec »

Now, do I want to change anything to our investments?

Chapters 1-2 seem like pretty basic stuff, but so far have been the most helpful for me. I’ve taken the advice and I re-did a detailed post-retirement budget in today’s dollars, using basic needs only. No travel, no cleaning service, no leisure activities, no restaurants, no $5k a year for unforeseen expenses, etc. As a result, our minimum acceptable post-tax retirement income went from $52k to $32k, assuming a couple in a paid-for house, and not enough maintenance to keep the house is perfect shape. This is a worst case scenario, a stress test, not something I’m actually contemplating... I’d really like to have the items that were cut from our budget, but we don’t need them to survive.

Then I looked at hypothetical early retirement at age 55 (in case I don’t like my job anymore then) and updated all my retirement income calculations, focussing on government pensions/benefits, and work-related DB pensions, with the latest numbers. Age 55-60: work pension only. Age 60: QPP starts. Age 65: work pensions get reduced because of adjustment for QPP. Age 67: OAS starts. I’ve assumed 3% inflation*, which reduces severely the purchasing power of the DB pensions over long periods of time (I am quite sure our plans will not offer any meaningful inflation protection by the time we retire*). Other sources of income are indexed, thankfully. We both die at age 90.

Conclusion: survival-type retirement income can be obtained using only these resources, even in the case of early retirement. This is a nice surprise indeed. In that scenario, anything in our RRSPs and TFSAs is extra and improves our lifestyle. Obviously, working longer would progressively bridge the gap between the ‘needs’ and ‘wants’, again using only govt pensions/programs and workplace pensions. Therefore, using the logic presented in the book, we could go 100% stocks in our personal portfolios, we don’t need any RRBs or nominal bonds at all. I don’t plan to do this, but it’s reassuring that we could increase equities and still be confident of having basic needs covered. It means that we have not been taking too much risk without realizing it.

The next step is go back to the much more comfortable $52k after-tax retirement income goal and see what this implies, i.e. what proportion of personal portfolios need to be in safe assets, given retirement at age 55, 60 or 65. I also need to look at what happens if one spouse dies early, especially the one with the much bigger workplace pension.
_____________

* Added later: this should have been phrased better. There is inflation protection in my DB plan, but only beyond 3%. For milder inflation, pension indexation depends upon the financial health of the plan, and this clause has been suspended for over 10 years, so I'm not counting on it.
Imagefiniki, the Canadian financial wiki: a knowledge base of financial subjects written from a Canadian perspective
Post Reply